Tuesday, January 17, 2012

The Sears Collapse: Conspiracy or Cluelessness…or Worse?

Since “Hellhound on His Trail” came out in the spring of 2010, I’ve had occasion to think anew about the many conspiracy theories that swirl around the story of the King assassination…a lot of perfectly sane people believe that Martin Luther King was killed as a result of a vast, shadowy conspiracy.

—Hampton Sides, author, “Hellhound on His Trail.”

This being the weekend America honored MLK, we’re recalling that lament of the above-quoted author Hampton Sides—whose excellent, compelling account of the largest manhunt in FBI history is worth buying, right now, on your Kindle or iPad—about the persistence of weird conspiracy theories surrounding what was, in fact, the well-documented assassination of one civil rights leader by one sorry but clever-enough jailbird, as we consider the persistence of a weird conspiracy theory about a once-proud retailer brought low by one genius of a hedge-fund manager.

We speak, of course, about Sears.

The conspiracy theory, lately making the rounds on Wall Street, stems from the fact that the hedge-fund genius, Eddie Lampert, who also happens to be Sears’ board chairman, recently purchased nearly 5 million shares of Sears, mostly from his own hedge fund, at a price of close to $30 per share.

The conspiracy theory hinges on three verifiable facts: 1) Eddie Lampert is an extremely smart guy with a terrific track record; 2) Sears under Lampert has become even more of a basket case than it was before he took control; and 3) despite the obvious collapse in Sears’ business model, Lampert had been using Sears’ own coffers to buy up stock in the open market at absurd prices that were far higher than what he just paid for the stock, rather than invest in the business itself.

And on all three facts, the conspiracy theorists are correct. Lampert is smart—witness his success with AutoZone. And he has been using Sears’ own cash to buy stock in the open market at absurd prices, in hindsight:

As for the notion that Sears has become a retail basket-case, look no further than the credit default swap market in Sears Acceptance Corp—the Sears financing arm—and you’ll see they have blown out to levels that even the calculator-impaired credit monitors at S&P would recognize as, er, stressed.

“Why then,” the conspiracy theorists ask rhetorically, “would Eddie have bought back all that stock for the company at stupid prices before buying stock for himself cheap?” Their answer—and while we’re paraphrasing what we’ve heard, we’re not making up the gist of it—is this:

“Eddie wants Sears to go bankrupt so he can take control of the real estate and make a ton of money.”

And while the conspiracy theory seems to wrap up a lot of loose ends, it does not take into account the most obvious notion, which is that Eddie got Sears wrong.

By way of demonstrating just how wrong he may have gotten it, we herewith present a sample of howlers from various Sears filings over the years:

[Sears] completed development of new Internet technologies and migrated our selling websites to an improved e-commerce platform. This new platform positions us to attract and retain customers using a multichannel service approach to create a consistent experience across the channels and enhance the offerings and the shopping experience where channels intersect. Examples include store-to-Web, Web-to-store, special order catalogs and the sales hotline. Multichannel represents the potential for a sustainable growth vehicle for our company and represents an opportunity for us to unify and integrate the customer’s experience.

…in August 2007 we introduced the Ultimate Appliance Promise campaign. The purpose of this campaign is to show our customers that we are uniquely positioned to meet their appliance needs by offering the largest selection of appliances, a price guarantee, one year of free service and support, and next day delivery and installation in many markets across the U.S.

[Sears] remodeled approximately 30 Kmart stores to include Sears-brand products. We intend to continue our rollout of home appliances, including Sears Kenmore-brand products, into Kmart locations over the next several years as a means of expanding our points of distribution in response to competitor store growth. As of February 2, 2008, approximately 280 Kmart stores, including certain of the remodeled locations, offered broad assortments of home appliances.

MyGofer expanded its fulfillment options in a variety of ways, as well as serving as the engine behind additional integrated retail efforts. MyGofer.com provides features and benefits designed to create a one-stop shopping experience, offering a range of quality products including groceries, prescriptions, health and beauty products, and electronics. MyGofer was created to provide our customers with speed and convenience – the same day a customer places an order, it is ready within hours, with pickup now available in over 600 stores.

And, our favorite:

With regards to social media, we deployed a variety of campaigns and applications to make our experiences more engaging and “sticky,” both on sites like Facebook and Twitter, as well as on sears.com.

Maybe—just maybe—like when a loser from a broken home of whom nobody had ever heard managed to kill the leading civil rights leader of his times and almost get away with it, the facts are just the facts.

To support this perspective, we now harken back to an early report on Sears that spookily heralded everything that came afterwards: a 2006 Fortune Magazine piece in which Lampert is called “The Steve Jobs of the investing world,” yet contains enough evidence of the penny-pinching narrow-mindedness that destroyed Sears to be almost prescient:

The mood was tense at the Bel Age Hotel in West Hollywood, Calif., early last year. The top two dozen executives of Sears Roebuck & Co. were gathering for a strategy session with Eddie Lampert, then 42, the billionaire hedge fund manager who had just engineered an unlikely takeover of their venerable but struggling company. The fact that the vehicle of his acquisition was discounter Kmart--which Lampert had come out of nowhere to snatch control of during bankruptcy--was only one source of unease. Once their presentations started, Lampert also began poking holes in virtually every idea. "What's the benefit of that?" he asked again and again. "What's the value?" He shot down a modest $2 million proposal to improve lighting in the stores. "Why invest in that?" He skewered a plan to sell DVDs at a discounted price to better compete with Target and Wal-Mart. "It doesn't matter what Target and Wal-Mart do," he declared.

Eyes began rolling…

—Patricia Sellers, Fortune Magazine, February 8, 2006

And the eyes should have rolled. Because, as it turns out, it does matter what Target and Wal-Mart do, just as improved lighting does matter in stores where women bring children to shop for clothes.

How much such things matter is evident in the numbers ever since Eddie began second-guessing the expenditure of cash on anything, it would seem, excepting high-priced stock.

From 2006 to 2010, Target and Wal-Mart together spent $16 billion and $33 billion, respectively, on capital upgrades to their businesses (we’ve arbitrarily cut Wal-Mart’s actual capital expenditures of $67 billion in half, to account for the company’s international spending). Sears, meantime, spent a miniscule $1.4 billion, or about 3% of Target and Wal-Mart combined—and less than a quarter of the share repurchase cost—on silly things like “improved lighting.”

The result? While Target’s annual cash flow from operations grew from $4.9 billion to $5.3 billion in that time, and Wal-Mart’s grew from $10 billion to $12 billion (again dividing that company’s total figure in half), Sears was watching cash flow from operations drop 90%, from $1.4 billion—almost 10% of Target’s and Wal-Mart’s combined cash flow—to a nail-biting $130 million…which is less than 1% of its rivals.

And Sears has done that while generating over $40 billion in annual sales—not easy to manage, negatively-speaking-wise.

None of this, of course, is new-news. The 2011 numbers, previewed last month, were even bleaker for Sears.

But beyond the obvious value destruction and the conspiracy theorist-like attempt to reconcile conflicting facts, the company’s recent performance and its chairman’s ensuing share purchase in January raise a rather obvious question that doesn’t appear to have crossed any minds in the press corps: why is it that Eddie Lampert, who directed Sears Holdings’ share repurchases of 55.6 million shares at an average of $104 over the 2006-2010 period, bought for himself rather than for Sears Holdings those 4.8 million shares at around $30 a share (technically the 'purchase' was likely an allocation of his annual performance fee in stock, but still...)?

After all, a company that had spent nearly $6 billion on its stock at an average price of $104 would presumably have found the shares even more attractive at $30.

Wouldn’t Sears Holdings have liked to average down?

To the conspiracy theorists, the answer is self-evident: it clinches their view that Eddie has purposely been buying back stock at silly prices in order to shrink the share base and drive up his personal percentage of the remainder, while simultaneously disinvesting in the stores so aggressively that the Sears parking lot is the only place to find a space at the mall during the holidays, making it worth more to Eddie dead than alive.

But we don’t buy it.

We think Eddie’s mother, quoted in the above Fortune article, had it right:

“I never thought he would go into retail,” Dolores Lampert says. “It's a very hard business. But it's a challenge, and Eddie likes a challenge.”

Still, if Warren Buffett is looking for scapegoats on Wall Street, he might want to direct some attention to Sears. Unlike Staples, for example, which private equity nurtured and grew into an industry-creating powerhouse, here’s a business that was an industry-creating powerhouse that has, pretty systematically, been destroyed by private equity.

Retail is indeed a very hard business.

Jeff Matthews

Author “Secrets in Plain Sight: Business and Investing Secrets of Warren Buffett”

The content contained in this blog represents only the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

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19 comments:

Dave
said...

It's incomprehensible that anyone - other than a certified lunatic - could spend as much money as Eddie Lampert has to buy Sears and K-Mart, only to run them both into the ground. It's the paradox of modern capital markets making money while destroying value.

I don't understand the logic that Lampert buying stock here means he wants it to go bankrupt. If he wanted it to go bankrupt, why would he buy the stock for his own fund/account?

As for the RE theory, hasn't that been debunked by now? There are plenty of Circuit City, Border's, and other bankrupt big box retailers whose real-estate is currently on the market. Not sure the real-estate of Sear's and Kmart has much value whatsoever.

As for the question of the article, I vote for cluelessness - it would have been a hard job for anyone to turn around Sears and Kmart. I think they were dead before Eddie got there - he probably just accelerated the complete demise by a few years.

It will be interesting if JC Penny does any better than Eddie with the former head of Apple's stores there. I would bet that they are unsuccessful even if they invest heavily in reviving that dead concept.

I think Eddie got into this thing at a bargain price but has found out it's a lot tougher to turn around than he planned. It's no Autozone that's for sure. And conditions have changed the last half dozen years. Now he's burning cash and has to decide what to do. One option is to take it private and sell off the valuable pieces and shut down the rest. Ugly for the employees but probably the best way out of a difficult position for Eddie. he can probably still get out with a profit if he moves quickly. The longer he waits the worse it gets.

The difference between those other companies and Kmart/Sears is that those other companies did not need rescuing. Lampert is a great stock picker. He has decided to find out whether he is a great manager as well. So far, Kmart/Sears is kicking his rear end.

It's a bit mystifying, really, because Sears Roebuck was Amazon before Amazon. I had thought they would turn SR around by digitizing their catalog and making the stores more like showrooms, much like they did when I was a kid in Seattle and the giant Sears store/warehouse (now Starbucks) was right on the rail yard on the way to downtown. They could have leveraged the logistical system they had in place, minimized held stocks in favor of JIT delivery from centralized facilities in the land cheap midwest for their large goods, and put a little more money into making the stores they had less ugly and more inviting. Kenmore, Craftsman, and other Sears brands still have legs for boomers and nostalgia appeal for hipsters (Hilary outdoor gear, Ted Williams sporting goods). Nordstroms owns the attractive store experience-mood lighting, live music, attractive and helpful staff, cafe and coffee places. Spin off K-mart or make it the mid-zone between Target and WalMart, leverage Sears for its brand strengths (hard goods), spin off Lands End.As for conspiracy theories, to me it always seemed like there were policies and policy alternatives. Nobody wants to be found out as the guy that pulled the trigger but there are lots of people to egg on the guy that might. Is it any different than business? Not when the government is run by business people (from Wall Street to the Mafia, it's about business).

ELS always had 1 go to financial engineering move: use stock buybacks with whatever cash assets were available to boost earnings then find some street analysts to characterize the YOY earnings change as ""growth".

While it worked with Autozone, it was a simple game that was bound to be called out at some point. The dumb retail accounts that bought this nonsense must have bought alot of other nonsense and now they don't have funds to buy into the fantasy engineering world of EL.

What amazes me is that he was able to get away with it in the first place.

Mr. Lampert is a very smart man, but not everything a very smart man does works. It is absolutely true that most retail sales initatives fail, but that doesn't mean that one will succeed with no sales initatives. Sears was broken before Mr. Lampert got involved, and there is a mismatch between his philosophy of retailing and what is wrong with Sears.

What I am saying is that the price of the BYD stock had gone up 4x when they decided to make the purchase (after months of probably saying no to the investment) - because Buffett was allowed to make the purchase at the initial price. So, he was given a 400% return for free. This I didn´t know. Also, Buffett makes it clear that he is not too confortable with the technological aspects of the company.

It has "worked" only because the Berkshire investment created a bubble in the stock following the announcement in 2008, as you know.

Since then, sales and earnings have missed expectations, and cash flow has been so poor the company was forced to raise equity last year on the Shenzhen exchange.

Moreover, the real reason Berkshire invested--the company's purported lithium battery technology, which Charlie Munger has discussed at the annual meeting in response to questions from shareholders following numerous disappointing setbacks--looks like a bust. It is not commercially viable at this point, having missed the deadlines from past announcements.

The stock peaked at HK88 in 2009 and is now down 74%, as you also know. Last fall the stock was back close to Berkshire's cost but has since recovered some with the China market, providing the sexy-but-misleading annualized return cited above.

All in all, as Berkshire investments go, BYD has been a disappointment.

Burlington Northern, on the other hand, has been an absolute home run, as we anticipated in these virtual pages despite much skepticism at the time.

The point I´m trying to make is that the only reason Buffett accepted this investment is because the founder of the company offered him some shares at $8, eleven months later when Buffett still wasnt convinced of the investment the stock was quoted at $40, Buffett tried to back out of the deal but the founder let it go at the original price. This means that there was an instantaneous 400% return on the investment + a margin of safety of 80% from entry price.

Has anybody here recently shopped at Sears? I grew up wearing Tough Skins jeans. They wore like fiberglass which pleased my mother no end. Bought my first fishing road and reel there with chore money, a Zebco. I have rebuilt a BMW 1971 6 cylinder and restored my 1965 Mustang with craftsman tools. Once I had to bleed a Diesel engine on a sailboat in a gale with my tools. I really like my Craftsman tools. I have slavishly followed Consumer Reports advice and populated my house with many Kenmore appliances. My wine collection is cared for by Kenmore. I’ll offer this one of many anecdotal experiences to explain why I don’t even consider shopping there anymore. I could hire a landscaping crew to care for my property but the ghost of my frugal New England mother won’t permit it. I can hear her now, “Mr. big fancy pants is too big now too even take care of his yard”. So instead of a gym membership I do yard work and torture my kids by making them do the same. New Englanders think this kind of work “builds character” and saves money; heaven. This year I had to get some help with the leaves and needed another rake. I left the house and headed to Home Depot. On the way I thought that I’d give a closer Sears a try and save some time. I hardly ever shop there anymore but I was only looking for a rake. How difficult could that be? I went in and asked a kid sitting at a desk where the rakes were. He said nothing but pointed in the general direction. As I got close to the garden tool section he shouted, “I think we’re all out”. It was late October (I live in NJ) and Sears had no rakes! I then drove to Home Depot and they had bins full of rakes. Out of curiosity I then stopped in the local Lowes, tons of rakes. My wife reported that Target had rakes. A friend and I were discussing this and we joked that Sears didn’t need ex IBMers and fancy IT systems to fix the problem, we both knew how to get Outlook to remind us to order rakes for fall.

PS: I still can’t figure out where Mr. E.L. has parked the craftsman and Kenmore trademarks / brands within the corporate structure. Who owns them and aren’t they some of Sear’s most valuable retailing assets?

One correction on this BYD thread: Buffett did not "try to back out" of the deal and the "only reason" Buffett bought the stock was not because the founder offered it to Berkshire at a discount.

Buffett bought the stock because Charlie Munger, who had owned it for years, encouraged Buffett to buy it for Berkshire. Buffett sent later-disgraced David Sokol to China to vet the business. Sokol liked what he saw and encouraged the investment.

Buffett never tried to "back out" of BYD--his point was that BYD could have tried for a better deal following the price rise that came with the Berkshire announcement, but didn't. Buffett appreciated that.

Read our book: Buffett doesn't buy stuff just because it goes up: he wants to buy a good business, one he understands, with a defensible moat, at a reasonable price, with honest management. BYD has almost none of those attributes, as it turns out, except he bought it at a price that gave him that 'margin of safety' he looks for.

Jeff, I read your book and other books about Buffett and my conclusion is that Buffett buys things to make money.

Hence my conclusion that the way he described the transaction in the article referred above seems to me that he was going to back out of the deal, but since the founder kept the original terms, he accepted to purchase.

Please note that Buffett explicitly says that he still doesnt understand the business. This makes me conclude that he bought into it just because even without understanding the business (which is agaisnt your argument that he only buys good businesses), Charlie seemed to understand and so did Sokol, so he thought that the margin of safety was good enough making an instantenous 400% profit.

Also, please refer to the last chapter of "The Intelligent Investor". Almost every business (however good or bad) has its price. It´s clear to me that that was the reason Buffett accepted the deal.

When it comes to conspiracy theories, one statement always comes to mind. "I just don't think they are smart enough to pull all that off." This statement has always grounded me in every conspiracy theory I hear. In this case, I think it's simple cluelessness and this opinion was validated in Feb of 2009 in the SHC letter to Shareholders from ESL. His letter was 15 pages long and 12 of them were all about the crash in 2008. Nothing to do with the retail business who's logo was on the cover. His manifesto then validated he knew nothing about retail and wanted to know nothing about retail. Honestly, if you were an investor of retailers and having read that manifesto would you invest in this business? Then again, maybe he is THAT SMART?